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Section 409A – action steps required in 2007

This advisory focuses on action steps that must be taken during 2007 to comply with Section 409A. Accordingly, this advisory presents only a very general overview of the requirements of Section 409A.

What is Section 409A?

In April 2007, the Internal Revenue Service issued final regulations under Internal Revenue Code (“Code”) Section 409A. Section 409A applies to certain nonqualified deferred compensation plans and arrangements and is generally effective for compensation deferred and vested on or after January 1, 2005. A more complete list of plans, agreements and arrangements that may be subject to Section 409A is included with this advisory.

Section 409A defines a nonqualified deferred compensation plan very broadly to include any plan that provides for the deferral of compensation. In its simplest terms, a deferral of compensation occurs if a participant has a legally binding right in one year to receive a payment of compensation that will or could be made in a later year.

Example: An executive’s change-in-control agreement provides that the executive will receive a severance payment if his or her employment is involuntarily terminated in connection with a change in control. This promise is potentially subject to Section 409A because the executive is performing services in a current year for a promise that could be paid in a future year if a change in control occurs.

Example: An executive participates in a deferred compensation arrangement under which the executive elects to defer the receipt of a portion of the executive’s salary and bonus until termination of employment. This arrangement is potentially subject to Section 409A because salary earned in the current year will potentially be paid in a later year.

For any plan or arrangement subject to Section 409A, Section 409A imposes certain restrictions on the time and form of payment of deferred compensation (including possible delays in receiving benefits for at least six months following termination of employment for any “specified employee” (key employee) of a public company) and limitations on the timing of initial and subsequent deferral elections. Section 409A also generally prohibits accelerated payments of deferred compensation, places restrictions on funding and adds requirements for reporting and tax withholding of deferred compensation amounts.

Deadline to Comply with Section 409A – December 31, 2007

All plans and arrangements subject to Section 409A must be brought into documentary and operational compliance with Section 409A by December 31, 2007. All plans and arrangements subject to 409A, including employment agreements, change-in-control agreements, severance arrangements, equity plans, deferred compensation plans, SERPs and any similar plans and agreements should be reviewed and examined to determine whether amendments are necessary to comply with the provisions of Section 409A. In our experience, many, if not the majority of, plans and arrangements subject to Section 409A will need amendments before the end of 2007.

Impact of Section 409A Failures

If at any time a deferred compensation plan or arrangement subject to Section 409A fails to comply with the provisions of Section 409A or fails to operate in accordance with such provisions, participants under the plan or arrangement (including current and former executives, employees, directors, independent contractors or other service providers) will face harsh tax penalties. In particular, all compensation deferred under the plan or arrangement for the current taxable year, as well as for all preceding tax years, will be immediately includible in taxable income for the current year (to the extent the compensation is not subject to a substantial risk of forfeiture). In the event that Section 409A requires amounts to be included in an individual’s taxable income, interest and penalty taxes will also apply. In particular, the tax imposed will be increased by (i) an enhanced interest rate retroactive to the date of the original deferral of compensation and (ii) a penalty tax equal to 20 percent of the amounts included in taxable income.

Generally, if a plan or arrangement subject to Section 409A fails to comply with the required provisions, the taxable event will apply only to the participants to whom the failure relates. However, all plans or arrangements subject to Section 409A of the same type (e.g., account balance plans, non-account balance plans, etc.) will be aggregated and affected by a Section 409A failure. Therefore, the failure of one plan or arrangement to comply with Section 409A can potentially trigger additional Section 409A failures.

Although the major impact of Section 409A is felt on an individual participant basis, plan sponsors are generally responsible for reporting any compensation deferred under a Section 409A arrangement and for withholding income taxes when such compensation is required to be included in taxable income.

What Should Plan Sponsors Do Now?

Because the deadline to adopt plan amendments and fully comply with the provisions of Section 409A is December 31, 2007, employers and plan sponsors should begin now to review all compensation plans and arrangements to determine whether such plans and arrangements are subject to Section 409A. All plans and arrangements subject to Section 409A should be reviewed to determine whether amendments are necessary to comply with the final 409A regulations and provisions. Any necessary amendments must be adopted before the end of 2007 in order to avoid the harsh penalties associated with Section 409A failures.

We suggest the following five-step process to identify and amend all arrangements subject to Section 409A during 2007. To accomplish each of these steps before December 31, 2007, action must begin in the very near future (if it has not begun already).

4. Prepare any necessary amendments and communicate any necessary changes to participants, plan administrators and recordkeepers

5. Execute and adopt necessary amendments before December 31, 2007

1. Identify All Potential Section 409A Plans or Arrangements

Section 409A defines a nonqualified deferred compensation plan very broadly to include any plan or arrangement that provides for the deferral of compensation. A deferral of compensation occurs if a participant obtains a legally binding right during a taxable year to receive compensation that is or may be payable in a later taxable year. In other words, all plans (subject to certain exceptions described below) that provide for participants to earn compensation in one taxable year, but pay the compensation in a subsequent taxable year are potentially subject to Section 409A. This may encompass arrangements that are normally not considered deferred compensation plans. Each of the following examples demonstrates an arrangement potentially subject to Section 409A and demonstrates the broad range of arrangements that are potentially subject to Section 409A:

# Employer grants nonqualified stock options in 2007 that are exercisable in 2008 or later

# Executive has an employment agreement that calls for a cash bonus upon a change in control of the employer

# Executive has a severance agreement with an employer that provides for certain payments upon the executive’s termination without cause or resignation for good reason

# Executive has an indemnification arrangement with employer under which the employer agrees to reimburse executive for costs or legal fees arising out of claims made against executive

# Employer has an employment agreement that provides for reimbursement of medical expenses for three years following separation from service

Certain types of arrangements are specifically exempted from coverage under Section 409A, including but not limited to, qualified retirement plans described in Section 401(a), annuity plans described in Section 403(a), annuity contracts described in Section 403(b), a SEP within the meaning of Section 408(k), a SIMPLE account within the meaning of Section 408(p), an eligible deferred compensation plan under Section 457(b), bona fide vacation leave, sick leave, compensatory time, disability pay or death benefits and certain non-taxable health reimbursement arrangements.

2. Review for Compliance with Section 409A

Certain arrangements that would otherwise be subject to Section 409A may, if drafted properly, be considered exempt. Examples could include stock options and stock appreciation rights, severance arrangements and certain short-term deferrals. Certain plans may also be grandfathered and exempt from Section 409A. All plans and arrangements potentially subject to Section 409A, however, should be reviewed to determine if an exception is appropriate.

For plans and arrangements that are subject to Section 409A, important restrictions imposed by Section 409A apply to certain “specified employees,” initial and subsequent elections to defer compensation and elections regarding the time and form of distribution of benefits from the Section 409A arrangement.

Specified Employees. For certain “specified employees” of public companies, Section 409A provides that a payment of deferred compensation related to separation from service may not occur before the date that is at least six months after the date of separation from service (or, if earlier, the death of the “specified employee”). Plan documents must specifically include this six-month delay provision in order to comply with Section 409A and must specify how the “specified employees” will be identified. A “specified employee” is generally a key employee of a company with publicly traded stock (generally limited to the top 50 officers or certain owners of the company). The “specified employee” provisions are applied on a controlled group basis, so if any company within a controlled group has publicly traded stock (even if on a foreign stock exchange), the six-month delay provisions will apply to any key employees of the organization. The final regulations do permit employers to be overly inclusive in terms of identifying “specified employees”, but certain restrictions apply.

Elections to Defer Compensation. Under Section 409A, elections or plan provisions specifying the timing and form of payment (e.g., lump sum or installment payments) must be irrevocably made or specified by certain deadlines. Generally, the time and form of payment of the deferred compensation must be made before the beginning of the participant’s taxable year in which the services are rendered that give rise to the deferred compensation. Certain exceptions to this rule may apply, such as for performance-based compensation.

Distributions of Deferred Compensation. In general, payment of deferred compensation under a plan or arrangement subject to Section 409A may not be made except on (i) separation from service, (ii) disability, (iii) death, (iv) a specific time or pursuant to a fixed schedule, (v) certain change-in-control events, or (vi) an unforeseeable emergency. There are very limited exceptions for either accelerating or delaying payment.

3. Analyze Various Alternatives for Compliance with Section 409A

Non-compliant plans and arrangements must be amended and become operationally compliant by December 31, 2007. A variety of alternatives for compliance may be available. Certain transition rules may also be available until December 31, 2007, including the ability to potentially revise previously made elections as to time and form of payment.

4. Prepare Necessary Amendments and Communicate Changes

The final Section 409A regulations require that the material terms of all deferred compensation plans must be in written form. In fact, a plan or arrangement generally is not considered to be established for purposes of 409A until the latest of its adoption date, its effective date, or the date on which its material terms are set forth in writing. Material terms satisfying Section 409A must be contained in a written plan document no later than December 31, 2007. Deferred compensation arrangements have been required to be administered in good faith operational compliance since January 2005, but now that final regulations have been issued, there may need to be further refinements to how deferred compensation arrangements are being administered. Any changes made to comply with Section 409A should be communicated to participants, administrators and recordkeepers.

5. Adopt Amendments

In order to adopt amendments, plan sponsors may need the consent of affected service providers or approval by the board or compensation committee. Such approvals and discussions of available alternatives could require substantial time. Thus, the entire review process should start now.